Unmasking The VooDoo: Candlesticks
Anyone who is not familiar with technical analysis and charting might think – quite correctly – that technicians like three things – 1) the markets 2) jargon and 3) naming things after themselves. I cannot argue with any of that although I would add that there is a bit more to the naming thing. Technicians like to give things quite obvious names.
A triangle pattern looks like a triangle. A rectangle looks like a rectangle. And a head-and-shoulders looks like the Kilroy was here drawing from World War II.
Even non-technicians are somewhat familiar with bar charts. They use four bits of data – the open, high, low and close – for whatever period they cover and convey that periods action in one quick glance. And when we string them together, we can get a sense of what happened in the market over time.
Enter candlestick charts, or just simple, candles. While they seem new to some, they actually predate bar charts by quite a margin. The good news is that they use the exact same data to draw each period and we can string them together to get a sense of what happened over time.
So, what’s the big deal about them? The answer is that they add a new dimension to the analysis making it easy to see what happened during any one period even faster. A red or black filled candle is generally bearish while a green or white filled candle is generally bullish.
Again, same information as bar charts so there is really no actual advantage other than speed so far. But that is a big advantage when scanning a chart by eye to look for patterns and conditions.
Now let’s quickly talk about the major differences.
Big Fat Candles
There are two big differences between candles and bars. The first is that the open and close are far more important for candles than the high and the low. There are more patterns that emerge in candles. And there are more meanings.
The second difference is that candles have width. That means you rally cannot cram to many candles on a chart as charting service software will have to decide what candles will stomp on their neighbors and necessarily reduce their visibility and usefulness.
I am not going to dive into how to make candles and define the basic shapes. There are too many resources online to help with that. But because this is supposed to make your life easier, here is my stock graphic of the basics. Remember, a black or red or filled candle means the close was below the open. A white or green or non-filled candle means the close was above the open.
The next question is, “What about the highs and lows?”
The answer is that they are represented by the shadows or tails of the candle – the skinny parts that project above and below the fat part – called the real-body, by the way.
Are they important? They can be. Most of the time it is the lengths of these shadows that we care about and not their absolute price levels. Why? Because is tells us how much of a rally or decline within the day (or another period covered in the candle) was reversed. There is meaning in that. A giant rally that gave it all up by the close suggests weakness. A rally that closes near the high with a little upper shadow suggests strength.
The best part is that we can get real meaning by patterns as small as 1-3 candles, as well as more traditional patterns comprised of dozens of candles/bars using traditional indicators, such as RSI. Again, you can find jillions of sources for these patterns online so I won’t cover them here.
The point here is that candlesticks are very useful in that they quickly reveal intra-period changes. Said another way, we can see intraday changes on a daily chart that might be hidden in regular bar charts.
That brings us back to names. Candle patterns, thanks to the Japanese, who invented this stuff, have great names. Abandoned baby, dark cloud cover, two black crows and gravestone doji all portend bearish things ahead. Hammers, morning stars, three white soldiers and two rabbits suggest bullish things ahead.
Beats an inside-day or a flag any day.
Disclosure: No positions in anything covered.